Although families can cover the cost of college with student and parent loans, it is less expensive to save for college in advance. Saving money in a 529 college savings plan also provides flexibility in college choice in addition to reducing the need to borrow.
The total cost of repaying a loan often exceeds the total contributions to a college savings plan. You save money by avoiding the need to pay interest on the loans.
For example, suppose you save $250 per month for 17 years at a 4% average annual return on investment. You would accumulate a total of $73,116, with 30% of the total coming from earnings and $51,000 from contributions.
If, instead of saving this money, you borrowed $73,116 in Federal Parent PLUS loans at 7% interest with 4% fees added to the loan balance and a 10-year repayment term, you’d pay a total of $106,117, more than twice the total contributions. You’d also pay $884 per month.
Even if the repayment term were increased to 17 years, the monthly payment would be $640, more than double the amount contributed per month, and the total payments would be $130,459.
Tax benefits like the student loan interest deduction can reduce the cost of student loan debt, but it is still cheaper to save than to borrow.
The difference is that when you save, you earn the interest, but when you borrow, you pay the interest. The power of compound interest works in your favor when you save and works against you when you borrow.
Obviously, if the interest rate on debt is lower than the interest rate on savings, one could engage in arbitrage by borrowing to the limit and investing the proceeds, leveraging the spread between the return on investment and the cost of funds.
Although it is best to start saving when the child is young, when time is your greatest asset, it is worthwhile to save even when college enrollment is imminent. Every dollar you save is a dollar less you’ll have to borrow. Every dollar you borrow will cost about two dollars by the time you repay the debt, given the typical mix of interest rates and repayment terms. By saving money, you will literally save money.
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